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Date: April 21, 2017
Category: Credit

Q1 2017 Credit Report: Equity Bull Market and Fixed-income Investing

Equity bull market fixed income investingIn the first quarter, investment news was dominated by two key themes: rising interest rates and the bull market in equities. Both have important implications for fixed-income investors.

Equity markets have been rising steadily since their trough in 2009, and today stocks are trading at all-time highs. We are now eight years into the equity bull market, and in some ways, it feels like we may be at the top of the rollercoaster. Today’s equity markets are pricing in perfection. Markets have been buoyant since President Donald J. Trump took office. They appear to be pricing in the assumption that the Trump administration will deliver on its many market-friendly promises, including lower taxes, less regulation, and extensive infrastructure spending.

Equity bull market

However, as Congressional struggles around the repeal of the Affordable Care Act have illustrated, passing legislation in a gridlocked Washington is a challenge. Both tax reform and infrastructure spending are likely to face stiff opposition, and the healthcare bill’s failure has raised concerns about the administration’s ability to pilot legislation through Congress. In short, the legislative outlook is increasingly uncertain and markets are likely to react negatively to any further impediments to Trump’s pro-business promises.

At the same time, by many measures, market valuations look high. The Shiller cyclically adjusted price-earnings ratio (CAPE ratio) measures inflation-adjusted stock prices divided by a 10-year average of inflation-adjusted earnings. Developed by Nobel-prizewinning economist Robert Shiller, the CAPE ratio has been shown to be a reasonably successful stock market forecasting tool. The long-term average CAPE ratio for the S&P 500 has been approximately 15. Typically, when the CAPE is lower than 15, returns for the subsequent ten years have been strong, and when it is higher than 15, subsequent ten-year returns have been poor.

Shiller price-earnings ratio expensive markets

Currently, the CAPE ratio for the S&P 500 is 28.95, higher than it was in 1929 before the stock market crash and the Great Depression, but lower than it was in 2000, before the dotcom bubble burst. This suggests that stocks are relatively expensive compared to historical levels. While this does not necessarily mean that the bull market will turn bearish, it does suggest that there is a risk of a market correction. Related to high valuations, the S&P 500 has a dividend yield of less than 2 percent. This is unlikely to rise in the future.

Against this backdrop, a fixed-income allocation becomes more important than ever for investors seeking yield and potential capital preservation. However, the second key theme—rising interest rates—makes fixed-income investing more challenging.

When the market is trading at or near full value in a yield-starved environment, the last thing you should do is buy the market.

Most importantly, rising interest rates are negative for fixed-interest assets like government, corporate, and municipal bonds. Because they pay a fixed rate, these instruments are unattractive in a rising rate environment. Their value is likely to fall as they reprice to reflect new market realities. Therefore, investors seeking capital preservation and yield may be better served by floating-rate instruments like corporate loans, also known as leveraged loans or senior secured loans. Floating-rate instruments pay higher interest as rates rise, so they may be better positioned to deliver yield and retain their value in a rising rate environment.

Second, investors should be wary of investing in large bond funds that track the broader market. When the market is trading at or near full value in a yield-starved environment, the last thing an investor should do is buy the market. Instead, investors should consider smaller, nimble, actively-managed funds that are better positioned to seek out pockets of value and opportunity within the broader market.

Finally, as the risk of a market correction rises, investors may be wise to consider the structure of the funds in which they invest. Open-end, traded funds tend to be highly correlated with markets and when markets fall, such funds tend to see significant investor sell-off, which necessitates selling fund assets to cover redemptions. In contrast, closed-end funds may be better positioned to weather a downturn because their limited liquidity reduces the potential for an emotion-driven sell off.

To navigate today’s market environment, fixed-income investors should be strategic in their investment choices. Consideration of fund structures to minimize the impact of a potential market correction is important, as is selecting assets that can truly deliver the yield and potential capital preservation that a fixed-income allocation should provide.

Resource is the marketing name for Resource Real Estate, LLC, Resource Alternative Advisor, LLC, and their affiliates. Resource may distribute certain products through Resource Securities LLC, a wholly owned broker/dealer, Member FINRA/SIPC


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